Negotiating for the Long Term

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The goal of a successful term sheet negotiation is simple to explain, but often hard to attain.

Negotiating.

A word some people love and others loath. The difference between being a good negotiator and a weak one can make a world of difference in many walks of life, and entrepreneurs who consider it a weakness should spend time and energy to make it a strength.

All negotiations are not created equal. While the end goal should be to maximize the overall benefit to your side through the negotiation process, measuring this overall benefit is not always black and white.

When you negotiate the purchase of a car, measuring the success of the outcome is easy. You want the best possible terms on the transaction at hand meaning the lowest possible price for the car. You are unlikely to ever deal with the person on the other side of the table again, so the ongoing relationship does not matter, and there is no circumstance where the process or outcome is likely to affect a future negotiation. You can (and should) be as aggressive as possible, and leave no stone unturned in trying to get the best price you can. You can walk away with the salesperson thinking you are a total jerk who left nothing on the table for them and feel good about it (face it, these guys aren’t trying to be your friend, and don’t really care about your best interests).

When you negotiate a term sheet with an investor, you are negotiating a transaction that, if successfully concluded, will result in the party on the other side of the table becoming a key investor in your Company, likely a board member (who cannot be kicked off the board), and an important part of your long-term success or failure. The person across the table will be someone you interact with on a regular basis over the course of several years (and possibly over multiple startups), and they are likely to have a significant degree of input on whether you stay in your current role over the long haul. In other words, while the negotiation is about a short-term matter (the financing), the overall outcome of this process will have long-term implications, and as such you should not lose sight of this during the process.

We are not saying you should fold on key issues, or back down on terms that matter to you personally. You shouldn’t. However, as you represent your side in this process, you need to be cognizant of the impact this process will have on your long-term relationship with the investor. You should also use the process to continue learning about your potential new investor and the relationship that is forming between you.  If you are dealing with a quality, experienced investor, they will consider the negotiating process to be another key part of their due diligence work on your company (and you) – if they are not paying attention to how you manage the negotiation process and thinking about how this will translate into your ability to negotiate on behalf of the company after they invest they are not at the top of their game.

The best crafted term sheet will NEVER protect you from every potential situation where you could potentially be screwed over, so trying to negotiate to this outcome is a futile effort. You and the investor are going to have to trust one another when it comes to certain issues – if the negotiation process makes you feel you cannot trust them, then trust us when we tell you to walk away and seek an investor you trust to be above board and fair on issues that by their very nature will not be black and white.

This post will not get into negotiating tactics (a link to a useful resource for this is below), with one exception. Don’t forget one of the most basic, important, and commonly ignored tricks to negotiating – putting yourself in the other parties shoes. It is especially important given the ongoing relationship you will have with the other party.

So, put yourself in the investors shoes. What do they want to achieve in the negotiation process?

(1) They want to reach an agreement on the investment, within boundaries they deem acceptable.

(2) They want to learn how you operate in these situations, and whether they can trust you and have confidence in you negotiating on behalf of the Company going forward. This negotiation is part of their due diligence process.

(3) They want to feel wanted. They want to hear that they are an important part of your decision process, and that you value their involvement going forward.

(4) They want to get the best possible deal, and will sometimes not think of the long-term impact this will have on your relationship. In other words, it is very possible they will not be thinking about the long-term implications of this short-term negotiation. (If you are an investor reading this post, PLEASE re-read it and take this into consideration. We know you have negotiated dozens of transactions in the past and feel you have an upper hand as a result, but remember you are entering a long-term relationship with the entrepreneur and use this process to help them understand terms that may be simple to you, but are new and confusing to them. You will be happier for it in the long-run and they will rightly trust you more.)

We are putting together a series of articles about term sheet terms and will include some ideas for how to reach a reasonable outcome on a few of the key ones, but will not get into those here (trying to set a CapGenius record for the shortest post with this one….).

Aside from making up for a horribly long hiatus since our last post (long story, not very interesting unless you were part of it), the main purpose of this short post is simply to remind you that when negotiating a deal where you will have many and frequent interactions with the other party going forward, getting the best possible outcome on every term (the “damn the torpedos” approach) may not provide the greatest overall benefit to your side. Focus on the issues that really matter, select the ones you are willing to give on, and pick a few where you will need to find a reasonable middle ground.

Note:  If you are looking for a good resource on negotiation tactics we recommend “Getting to Yes” by Roger Fisher and William Ury. It’s a bestselller that is used at several top business schools, and is a short and well-written book. The link is for what looks like a new version of the book which we assume is an update (the link to Amazon is NOT an affiliate link and we have no financial interest in the book, whether you buy it or where you buy it from). We have not read the new version, but unless they managed to really screw up something since the old version, this one is worth reading.

What the heck is a “Secondary Sale of Stock” anyways?

Thanks to a combination of websites like SecondMarket and SharesPost. large Web 2.0 companies electing to stay private, venture firms deciding that purchasing “secondary” shares at billion dollar plus valuations still counts as venture investing, and the general fascination of the startup press (and community) around valuations and wealth creation (which is perfectly understandable), you have likely been hearing about secondary stock sales quite a bit recently. While it may be a generally understood term around Silicon Valley, we thought it might make sense to write a post to explain this term in a bit more detail to remove any confusion on the subject.

Primary versus Secondary Shares (for Privately-held Companies)

First off, lets make sure everyone is clear on this.  There is no difference between a primary share of stock and a secondary share.  In fact, there really is no such thing as a secondary share of stock. When you hear someone say “he bought secondary shares” what they really mean is that the buyer bought shares of stock in a secondary sale. The actual shares purchased are in no way secondary to other shares of the same class of stock.

The Primary and Secondary designations refer only to how the shares were purchased. More specifically, purchasing “Primary” shares means you are buying the shares directly from the Company and the proceeds from the stock sale go to the Company. If you purchase “Secondary” shares you are buying stock from an existing shareholder instead of directly from the Company. The shares being purchased on a “Secondary” basis were at some point in the past sold as “Primary” shares by the Company. Primary shares are sold by the Company in a variety of situations.  This first occurs when the founders of the business purchase their founders shares (hopefully at a very low Par Value per share). After the Company is operating, the most common situations where a privately-held Company will sell/issue primary shares are the following:

  • Investors in equity financing rounds
  • Employees and other option holders upon the exercise of stock options granted to them
  • Warrant holders (often a venture debt lender in the case of startup companies) when they exercise the warrant
  • An acquisition where the company is buying another business and paying for all or part of the purchase price with stock

Now that all of these different entities have shares of stock in the Company, they have some level of flexibility to sell those shares to third parties through a “Secondary sale” of stock. This flexibility will depend on a number of factors, first and foremost on whether there are any restrictions on their ability to sell shares of stock prior to a public offering of the companies shares.

Restrictions can include fixed prohibitions on the sale of shares (usually requiring the approval of the board of directors), Rights of First Refusal that give the company (and sometimes other shareholders) the right to purchase the shares instead of these being sold to a third party, and Rights of Co-Sale that allow other shareholders to sell some of their stock alongside the shares being sold in such a way that the purchaser is required to buy shares from a variety of sellers.

In addition to these restrictions, there will often be voting agreements in place that direct how the shares in question are required to vote on a variety of issues such as the election of the board of directors, approvals of new financing rounds, and approvals for acquisitions. For Preferred Stock there will be a Stock Purchase Agreement that outlines a whole range of terms and conditions that apply to that class of stock, regardless of whether it is held by the primary purchaser or sold to a secondary buyer.

There are also restrictions for sellers and buyers based on their level of sophistication as investors and their financial situation (buyers must be “Accredited Investors “). Both of the websites mentioned at the start of this article do a good job of outlining all of these potential restrictions on the shares and the process of buying and selling them.

Secondary Stock Sales in Angel/Venture Backed Private Companies 

Secondary stock sales are by no means a new phenomenon. Every share traded on public exchanges like the NASDAQ and NYSE is a secondary share. The proceeds from the purchases go to the current holder of the shares, with nothing going to the Company.

Until recently however, it was rare to see secondary sales of shares in private, venture backed companies. This was partly due to a reticence on the part of investors to buy secondary shares in private companies, and partly due to the fact that the process of handling secondary sales can be a cumbersome one.  This has changed significantly in the past four to five years and the trend towards a more active secondary market for private, venture-backed companies is clearly up and to the right (even the SEC appears willing to play ball and allow this market to expand, at least for now).

There are some negative aspects to this trend. Some are being addressed, some are unavoidable, and others have the potential to derail this emerging market shift. Here are a few of the key potential issues:

  • Impact on valuation of Employee Stock Options. A well-defined secondary market that sets prices for common stock based on market dynamics could be used by the IRS to determine the fair market value of common stock, and as a result the fair market value of stock options. Assuming the secondary market is inflated compared to internal valuations (we think this is a safe bet for the long term in the secondary market), these secondary trades could lead to higher stock option strike prices, which will reduce the attractiveness of the options to new employees, and in turn could make it more difficult for the company to recruit top talent.
  • Influx of new shareholders creates administrative headaches. Secondary stock sales bring new shareholders onto the Cap Table of a startup. This means the company now has to track a new shareholder, provide them with required notices, and seek their approval for issues where they have a voting right. In short, it adds an administrative burden that is exacerbated by the fact the new shareholder may well be completely unknown to anyone at the company, which is rarely the case with the angel investors and venture firms who purchased primary shares from the company.
  • The 500 shareholder limit. There has been a lot of news about the fact Facebook expects to surpass 500 shareholders sometime early in 2012. Going above this limit forces a company to provide disclosures in the same manner that public companies are required to disclose information. In essence, they will be a public company whether they want to be or not. There is active discussion with the SEC about changing this 500-person limit, but for the time being it stands. As an interesting aside, it is worth noting that this 500-person limit is one of the reasons venture investors insert Right of First Refusal and Co-Sale language into their financing documents. Without these terms in place, it is conceivable that a disgruntled shareholder could sell a small number of shares to a large number of people and effectively trigger the 500-person limit. We are not aware of this ever being done but include this note as one example of why venture financing documents are so damn long (if you have heard of a situation where this 500-shareholder trigger was even threatened, PLEASE add a comment below).
  • One Bad Apple.  The worst potential issue we see is that it only takes one “Bad Apple” to ruin this for everyone. At some point there will be a situation where secondary purchasers feel they were duped, and investigations will reveal “insiders” sold secondary shares of their private company based on information not available to the purchasers. This is really no different than insider trading issues for public companies, and if the amount of money involved is significant, and if it is proven there was fraud committed, we will see a quick backlash from both prospective secondary buyers and more significantly from the government, who rarely think of the impact of new regulations have on the startup community.

In spite of these and other issues, we generally see the Secondary Sale trend as a positive one for the startup ecosystem as it benefits most everyone involved (founders and employees of startups as well as startup investors). A strong secondary market will reduce the illiquid nature of privately held companies. If shareholders can “take a little off the table” along the way as opposed to having to wait for a 100% payday at some eventual company exit (acquisition or stock sales following an IPO) it will make it easier for companies to recruit talented employees who see the stock as an important part of the job offer, it will make it easier for venture investors to attract capital from LP investors who often cite the illiquid nature of venture investments as the primary issue they have with the asset class, and it will allow founders to not have all of their “eggs in one basket” and thereby make it easier for them to decide to turn down an early acquisition offer without fearing they are walking away from a personal fortune and could still lose everything if something goes wrong.

A number of companies and investors are still reluctant to embrace this secondary trend, with some companies taking steps to make it more difficult for shareholders (especially employees) to trade their shares prior to an IPO. While this is a natural reaction to a potentially disruptive new trend, we expect it to shift over time as startups that secondary trading of their shares have an easier time recruiting employees to the business based on the flexibility these employees have in terms of selling some of their shares as the business grows and founders see the value of being able to sell some of their ownership position along the way. This could lead to a greater degree of transparency by startup companies as they start to provide information related to financial results, equity capitalization and other important diligence items in an effort to make it easier for secondary purchasers to properly value the shares they are buying. Greater transparency will in turn increase the number of people willing to purchase secondary shares in private companies, which will only serve to support the emerging secondary trading market for privately funded companies.

Accredited Investor Defined

The term “Accredited Investor” generally refers to a SEC definition that is laid out in Rule 501 of Regulation D (Reg D for short).

The term is important for startup companies because the SEC allows startups to be exempted from most of the registration requirements for a company that plans to offer or sell its equity (think IPO registration documents…). These regulations were first put in place with the Securities Act of 1933 and have been updated from time to time since then. This is primarily of importance to startups that expect to raise a significant amount of outside capital, and in particular ones that are considering raising capital from Angel Investors (while VCs also have to qualify, it is a safe bet that any you have heard of qualify with no problems). If this does not describe your startup, there may be other exemptions you can leverage. In any situation you should discuss this in detail with your legal advisor.

  • Banks, insurance companies, as well as registered investment, business development and small business investment companies
  • Employee benefit plans with assets in excess of $5 million (note: Employee Benefit plans are a major category of LP investor in venture funds)
  • A director, executive officer or general partner of the company in question
  • A business where all of the equity is owned by Accredited Investors
  • A person who individually or jointly with their spouse has a net worth of at least $1 million
  • A person who individually has income over $200,000 in each of the most recent two years, or joint income with their spouse of over $300,000, and has a “reasonable expectation” of the same income level in the current year
  • A trust with assets in excess of $5 million that was not formed solely for the purpose of acquiring the securities in question

If you are a startup raising money from any investors (this is usually only an issue when individual investors are involved), it is your responsibility to ensure that each of your investors qualifies as an Accredited Investor. This is typically done by providing a questionnaire to each investor that among other things asks them to confirm they are Accredited. We would highly recommend that you take this process seriously and not “fudge” it to let in someone who does not fit the definition. The obvious reason of not wanting to get in trouble with the SEC aside, if an investor in your company turns out to not be Accredited, and then becomes a disgruntled shareholder, they can make your life miserable. It is not worth the hassle or risk, no matter who the person is (family, friend, only investing a small amount, etc.). This is true even if they falsely confirm they are Accredited when they fill out the questionnaire.

Rule 505 and 506 actually allow you to bring in up to 35 investors who are not accredited under certain circumstances (for Rule 505 it is the total amount you can raise in a 12 month period and for Rule 506 all non-accredited investors still must be “sophisticated” investors). However, with both of these exemptions you are required to make additional disclosures to the non-accredited investors that effectively amount to those used in registered offerings, which pretty much blows the entire point of getting the exemptions in the first place as the cost of preparing these documents in a manner that will give you all the legal protections desired is prohibitive for a startup.

Note – There are other exemptions in place that remove the “Accredited Investor” requirement in certain circumstances, but they are generally not as well defined and as a result startups are usually advised to allow Accredited Investors only.  Exemptions like the “Private Offering Exemption” sound like they would be useful, but for the purposes of angel-backed companies that plan to raise millions of dollars over time, you will likely want to stick with Accredited Investors only.

Eliminate Cliff Vesting on Option Refresh Grants

Consider this an “opinion piece”, but one shared between several founders and investors which in reality should not be a contentious issue anyways. In other words, we’re not going out on a limb here folks.

Simply put, you should seek board approval to change the vesting schedule of option grants to existing employees so that the standard one-year cliff vesting

period is eliminated. We’ll provide some of the thinking around this below which you should feel free to use in discussing the topic with your board.

First, lets spend two paragraphs on the ubiquitous one-year cliff.  Cliff vesting on option grants was initially added to option terms to provide a sort of “trial period” for a Company and employee. The trial period with equity is important because without it employees who are let go or quit soon after joining would all have a right to own equity (if they choose to exercise their options). This adds a potentially large number of small common shareholders who in some cases may not have a favorable view of the Company or the executives who fired them. This makes for a headache when seeking approvals from shareholders, both by adding a large number of small shareholders to the cap table, and by adding shareholders who may default to vote against the Company recommendations on key voting issues (getting fired can make one bitter…).

The one-year cliff is likely here to stay for new employees, and it should. If a potential hire says they want their one-year cliff eliminated they are showing they do not have a long-term commitment to the Company and/or do not trust that the Company has a long-term commitment to them. It should never be a point of negotiation, and a company should NEVER consider the upcoming end of a cliff vesting period as a factor in making a decision to dismiss an employee  – this ‘Lucy pulling the football away from Charlie Brown’ approach may seem like a decent idea in the short term, but it is a jerk move that signals you care more about equity than employees (good and loyal employees help make equity valuable).

So, given all of this, why eliminate the cliff period for refresh grants to existing employees? The primary reason is that if you have decided to give them more equity they are presumably doing at least an adequate job for your company and you intend to keep them around for a while. In other words, the “trial period” has ended and they have passed. Why subject them to another “trial period” with the new grant?

There are good reasons to make this change, and reasons to potentially not do it or not set it as a hard and fast rule. We’ll list them below and let you decide (PLEASE comment on this article with your opinion on the best approach).

Reasons to eliminate cliff:

  1. Goodwill.  Your goal with the refresh option grant may be to recognize an employee’s strong performance, great work on a crucial project or recent promotion, all positive things of course. When you tell the employee about their new option grant, telling them it is not subject to cliff vesting but will instead start to vest right away sends a further positive message about their importance to the business and your faith in their future success as an employee, and sends a very clear signal that their “trial period” has ended. It may seem like a minor thing, but we have seen this message have great impact a number of times (think of it as a really good icing on the cake).
  2. Administration of Options. This is a minor reason – tracking option grants without a cliff vesting structure is easier to deal with for both the company and employee, especially if the employee has multiple grants and only one is subject to a cliff. Again, a minor reason, but we wanted to find at least two good ones…

Reasons to maintain cliff or at least the flexibility to apply a cliff in certain cases:

  1. At-Risk Employees. There will be situations where you grant additional options to an employee as part of a package to keep them from leaving for a different job, or in cases where you are concerned they will leave for a new role and want to provide additional incentives for them to stay. In these cases you might want to use a cliff on the new option grant as you would not want them to walk out the door with extra vested options if they decide to leave in spite of your efforts to keep them on board. You can maintain a cliff structure on a case-by-case basis as explained below, so instead of using a cliff for all refresh grants, we’d recommend only applying it in specific situations where it may be warranted.
  2. Planned Dismissals.  If you are considering cutting one or more people from the Company in the next few months but are in the process of doing a broad option refresh, you may be in a situation where not providing the option refresh to the employee(s) you might let go could signal an issue to them that you do not yet want to signal. In this case you may decide to give them additional options along with the rest of the team as part of the refresh even though you know they may soon be gone. While you could apply a cliff vesting period to these grants as in #1 above, our recommendation is to not do this but instead provide the same refresh structure across the board. Two reasons for this – (1) You may not end up letting them go after all and (2) Unless it is a VP level person, the amount of new options vested in the time period between the refresh and their dismissal will likely be small, and there is a decent amount of goodwill in not trying to “nickel and dime” a departing employee over their option grants, especially as by default this person will have been at the company for at least a year (if not, their initial 12 month cliff would still be in place).

What about when an employee who is not at risk decides to leave within twelve months of this new grant? Without a cliff in place, an employee departure within twelve months of a new grant may cause some dilution as they will have the right to exercise options that would otherwise be lost to the cliff. While the dilution here is real, it should be fairly minor as most refresh grants are well under one percent of the overall equity and at most the equity lost would be eleven months of a 48 month vest, or about 23% of the total refresh grant. The main purpose of the original cliff is to avoid adding a short-timer to the cap table, but since an employee receiving a refresh grant already has vested options, setting a cliff on the refresh grant will not have any impact on whether or not they end up on your cap table.

Note on Option Refresh grants made prior to the one-year employment anniversary: For additional options granted to an employee who has not yet completed their first year of employment, so is still within their initial one-year cliff vesting period, you should include a cliff vesting period for the new options that expires on the same day that the original cliff period ends. In other words, apply a cliff vesting period on the new grant that runs until the one-year employment anniversary. This will prevent a situation where the employee is under the cliff for their original grant but starting to vest on a subsequent one and keeps the one-year cliff universally intact. Usually this period would only be a few months as it is rare to see additional options issued to an employee within the first six to nine months of their employment.

Implementing the change. You should not have to structurally change anything in your stock option plan to accommodate the elimination of the vesting cliff for refresh grants. Discuss this topic with the board and if there is approval, you can agree that unless otherwise noted, all future option grants to existing employees will not be subject to a cliff vesting period unless the employee is still in their first twelve months of employment, in which case the new grant will have a cliff period that ends on the same day as their existing option grant. Going forward you can default to this approach and simply notify the board if you have a refresh grant where you want to apply a cliff period and treat this as an exception to the rule.

We welcome comments on this topic and are interested to learn if you agree or disagree with the recommended approach. Please give us additional reasons (Pro and Con) as well – we appreciate the input.

Consider Repurchase Rights for Founders Stock

You took the leap and founded a new business. You and your co-founders have purchased your shares, own them outright, and are ready to go. Then someone suggests you should make these shares subject to a Repurchase Right. Huh?

Why should you agree to tie the shares you got for starting the Company to a right of repurchase that goes away over time similar to how employee stock options vest over time? There are a several reasons to consider doing this. We’ll name a few, but will first explain Repurchase Rights.

Repurchase Rights Defined

In the context of shares of stock, a Repurchase Right is a term that provides a party (or parties), typically the Company that originally issued the shares, to repurchase those shares from the shareholder who owns them. Repurchase Rights for startup companies are often used with Common Stock, in particular Common Stock issued to the founders of the business when the Company is formed. The Repurchase Right usually has a time-based structure meaning that the right to repurchase shares from the founder will lapse over a pre-determined time period.

What are the differences between a Repurchase Right and Vesting?

(1) The shareholder owns the stock subject to a Repurchase Right. Options Holders do not have any rights to stock options that are unvested.

(2) A Repurchase Right gives the Company an “option” to buy shares back from the shareholder under certain circumstances (typically upon leaving the Company). The Company does not have to exercise this right, and it must repurchase the shares from the shareholder (usually for the initial price paid). Failure to take these actions results in the shareholder keeping the stock that was subject to repurchase. With options subject to vesting the Company does not have to take any action on the unvested portion of the option grant if an employee leaves or is fired. These options revert to the Company automatically.

With Stock Option Vesting, if you leave during the vesting period you forfeit the unvested portion of your option grant. With a Repurchase Right, if you leave during the repurchase period you do not immediately forfeit the shares still subject to repurchase. The Company must elect to repurchase these shares and pay you for them. Usually the amount paid is equal to the original purchase price, but there are situations where the repurchase price is tied to the current value of the shares. Given that it requires a Company to come out-of-pocket to repurchase the shares, there are scenarios where the Company will elect not to repurchase. Many Repurchase Rights provide the right to repurchase to multiple parties in a waterfall structure. Usually the Company has the Right of First Refusal to repurchase the shares, but if it declines, this right will often then shift to investors in the Company with the right shared between them. If none of the parties who have a right to repurchase elect to do so within a pre-defined period of time, the shareholder will retain the shares.

We have seen situations where the Company and investors allowed a Repurchase Right to expire even when the business was doing well. Two examples of this include one where a Founder who was asked to step out of the CEO role and agreed with the new CEO that it made sense for them to depart the business, which they did amicably, and another case where the executive’s spouse had health issues and he wanted to spend more time with her so resigned from the Company with about six months left on the Repurchase Right clock but the Company decided it was appropriate to allow the right to expire.

The decision on whether to exercise the Repurchase Right is usually made by the Board of Directors, although the process maybe defined in a voting agreement which could provide for a different process to decide this matter. There are several potential conflicts of interest with the Board to consider. First, the departing shareholder might have a board seat and would clearly be an “interested party” when it comes to the Repurchase Right. Second, if Investors have a secondary right to repurchase, they might want the Company to waive its right so they can exercise their own repurchase rights. Legal counsel can help structure the repurchase terms to minimize these conflicts.

So, why should you consider tying at least a portion of your founders equity to a Repurchase Right? There are several reasons to do so – we cover four of them below:

When do you “earn” your shares?

Did you earn your founders shares for being there when the company was started, or is it implied, along with your co-founders, that you will have earned these shares for the time and energy you put into working side-by-side to make the business successful? It is usually a combination of these.

Founders often put in a meaningful amount of time, effort and sometimes also money before they formally start a Company. This should be recognized as should the simple fact the founder came up with the idea and took the leap to found the Company. However, great ideas seldom result in valuable outcomes without a group of people first putting in a significant amount of effort to turn the idea into reality. This is especially true since many businesses are successful based on business models and strategies that are very different from what was first envisioned when the business was formed. Execution matters A LOT.

As such, it is reasonable to put a structure in place that requires the founding team to “earn” these shares over time based on their ongoing engagement with the business as it grows and evolves.

Early Founder Departures

Ask any number of founders who had a co-founder bail on them for the “safety” of a high paying job at some big corporation but owned their shares outright and decided to keep them, how they feel about vesting founders shares. When you make the business a success, is it really fair that this person shares in the spoils in a big way? Doubtful.

Setting up a repurchase right on founders shares helps ensure each founder has a clear incentive to stick with the business and help it succeed, and forces them to make a hard decision if a different opportunity arises that they want to pursue. It keeps you aligned and keeps everyone motivated. To the extent any of the founders was planning to only stick around for a short period of time, setting up a repurchase right will encourage an up front discussion about this at the outset, which in the long-run will be a good thing.

Get Aligned with Employees

You will invariably expect early employees to accept a vesting schedule for their shares. While there are good arguments for how your founders shares should be treated differently, you should also consider the employees point of view and be aligned with them.

Showing your employees the importance of earning equity by having the founders earn it too can create a better working environment where everyone is in the same boat together. We’ve seen too many founders get frustrated that an engineer who owns .01% of a Company (on a four year vesting schedule) and makes less in cash compensation than they could earn at a large enterprise wants to go home at night while the founder (who happensto own 25% of the company outright) pulls all nighters to make the business work. This disparity will always exist, so anything you can do to bridge the divide is a good thing.

You’ll probably have to do it eventually anyways

If you end up raising outside capital, especially from venture investors, it is likely you will be asked to sign up to a repurchase agreement for some portion of your shares. In other words, you’ll be asked (required) to give up some of the stock you own outright and put it at risk based on your ongoing involvement with the company.

When this moment arises, one of the main points of discussion will be how much credit you should get for ‘time served’ and as a result how much stock should remain owned outright and not subject to repurchase. If you set a repurchase agreement up when you start the Company, and the terms of this are within the range of reasonableness (explained below), there is a good chance the investors will stick with the plan you have in place. Safe to assume they will also look favorably on the fact you already took this step as it shows you and your co-founders have a long-term commitment to the business.

The Range of Reasonableness

So, lets say you agree it makes sense to set up a Repurchase Right on your founders shares.  What terms are fair to the founders, and what will pass muster with future investors?

We cannot say with certainty as every situation is different, but here are a few things we’d recommend considering:

(1)  Keep 6-18 months for yourself. Assuming a four year vesting period, and that you have not been operating the business for more than 12 months, plan to keep between 6 and 18 months, or 12.5% to 37.5%, of the equity outright, and subject the rest to a repurchase right. The 6-18 month range is up to you, but two factors that argue for 18 months (or more) include a long incubation period where you worked on the idea before forming the business and a prior track record of success.

(2)  Tie the remaining shares to a Repurchase Right over three to four years. We typically recommend having the repurchase right on the shares lapse over the number of months left in the typical 48 months vesting period after subtracting the months you keep outright.  So, if you keep 12 months (25%) outright, you’d have 36 months remaining. An easier method is to just pick a repurchase period of three or four years (yes, the vast majority of founders select three years – go figure!). Three years is usually within the reasonable range that would be acceptable to investors.

(3) Protect Yourself – While we wish it were not the case, there are investors out there who will try to screw you over and you need to protect yourself. In terms of repurchase rights you should make sure you are protected from a scenario where the investors try to push you out of the business during the repurchase period in order to get some of your shares back into the Company (or worse, into their own hands). There are valid situations where investors want a founder to leave, but also those where the tipping point in the decision is the opportunity to pull back a bunch of stock from the founder. You should put a termination clause in the repurchase right that says if you are dismissed (fired) from the business without cause, that the repurchase right for at least some portion of the shares tied up will go away. If you leave on your own volition, the repurchase right stays in place, but if you are let go, the right goes away. If it is time for a founder to leave the business, having this structure in place will force the investors to work out an acceptable arrangement. Note the “without cause” statement – if you start to take actions detrimental to the business in an effort to get fired, you risk triggering a “for cause” determination which will nullify your protections. It is a reasonable structure as it helps ensure you don’t do bad things to get fired and keep your stock, while ensuring the investors do not fire you simply (or mainly) to get a bunch of your shares back.

(4)  Set up Change of Control protections. Item #3 protects you prior to the sale of the business, but after the Company is acquired you are dealing with a totally different set of decision makers. Ensure that all of the shares subject to repurchase have accelerated vesting for a change of control. We recommend a 100% Double Trigger which essentially means that if your business is acquired, and you are subsequently fired, forced to move outside of your current metro area, have your salary materially reduced, or have a significant change in your work responsibilities, the repurchase right ends and you own the shares outright. There is an arguement for a Single Trigger (repurchase right ends at change of control), but it does not usually pass the sniff test because part of the value in the acquisition is buying the team, including you. Look for another post that discusses Triggers (single and double) in more detail soon.

(5) Assuming you have good corporate counsel, discuss this with them to get their input on what terms you should consider in setting up the repurchase right. They should have some boilerplate terms from other deals that they can provide.

So, are you convinced that applying a Repurchase Right to founders shares is a good idea? If not, PLEASE include a comment to tell us why. If you are unsure, let us know what questions/concerns you have. If you have other reasons to consider having, or not having repurchase rights, please include these as well. If you found the article helpful, please comment to let us know (we like getting feedback), and please share it with others on Twitter, Facebook or a link from your website/blog.  Thanks!

Source: capgenius.com

Category: Forex

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